Final Dissert

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1. Introduction
The financial sector plays an important role in the economy of any nation. A well
regulated and well-developed financial sector is vital to achieving the most basic
need of efficient allocation of scarce resources. An article by EnnisKnupp
estimates the world total investable market capitalization as on December 2005
as $93.7 trillion. It can be observed from Figure1 that the % of emerging market
stocks is less than 2%. So there is a huge growth opportunity over the next few
decades
However according to Business Line dated September 9, 2006 an international
survey of 175 fund managers, conducted by Standards & Poor's suggests that
emerging market stocks now account for a high 16 per cent of all global equities.
Figure 1: World Total Investable Capital Market
Total Investable Capital Market (December 31,2005)

Emerging Market Stocks
All Other Stocks

2%
17% Cash Equivalents
21%
1% Emerging Market Debt

6% Non-US Bonds
4%
High Yield Bonds
3%
US Bonds
24% Real Estate
21%
1% Private Capital
US Stocks
Source: UBS Global Asset Management, Venture Economics, EnnisKnupp
The far-reaching changes in the Indian economy since liberalization in the early
1990s have had a deep impact on the Indian financial sector. The financial
sector has gone through a complex restructuring, capitalising on new
opportunities as
ALLIANCE BUSINESS SCHOOL

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well as responding to new challenges.
During the last decade, there has been a broadening and deepening of financial
markets. Several new instruments and products have been introduced. Existing
sectors have been opened to new private players. This has given a strong
impetus to the development and modernization of the financial sector. New
players have adopted international best practices and modern technology to offer
a more sophisticated range of financial services to corporate and retail
customers. This process has clearly improved the range of financial services and
service providers available to Indian customers. The entry of new players has led
to even existing players upgrading their product offerings and distribution
channels. This is particularly evident in the non banking financial services sector,
such brokerage industry, where innovative products combined with new delivery
methods are allowing the sector to achieve very high growth rates.
Over the past few years, the sector has also witnessed substantial progress in
regulation and supervision. Financial intermediaries have gradually moved to
internationally acceptable norms for income recognition, asset classification, and
provisioning and capital adequacy. The past decade was an eventful one for the
Indian capital markets. Reforms, particularly the establishment and
empowerment of securities and Exchange Board of India (SEBI), market-
determined prices and allocation of resources, screen-based nation-wide trading,
dematerialisation and electronic transfer of securities, rolling settlement and
derivatives trading have greatly improved both the regulatory framework and
efficiency of trading and settlement. The National Stock Exchange (NSE) and the
Bombay Stock Exchange (BSE) are among the top five exchanges in the world
with respect to the number of transactions.
The portfolio flows have been one of the major forces that has changed the
quantum and nature of international capital flows to India. Portfolio flows include
the investment in ADRs/GDRs and offshore funds in addition to investment by
Foreign Institutional Investors (FIIs).

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The FIIs are finding good company in domestic Mutual funds (MFs) in terms of
inflow in to Indian equity market. The increased MF inflow in the recent past has
been supported by the lot of money raised through IPO finding its way to the
market.
1.1 Research Motivation

FII has a very short history in India. Prior to 1992, only non-resident Indians
(NRIs) and overseas corporate bodies (OCBs) were allowed to undertake
portfolio investment in India. All this changed from September 14th, 1992 when
in line with the recommendations of the High Level Committee on Balance of
Payments ,foreign institutional investors (FIIs) were allowed to invest in the
Indian debt and equity markets. Repatriation of income was allowed, the ceilings
of FII investments were progressively relaxed, and they have also been allowed
in other segments of the market such as Futures and Options.
The emergence of Foreign Institutional Investors (FIIs) as a force in India’s

capital markets is an important part of the story of economic reforms initiated in
1991.FII inflows and outflows and conditions in the international markets are
today constantly monitored for clues to the direction of FII flows into the country.
A drying up of inflows is seen as pulling down the stock market and keen interest
on the part of FIIs is seen as signalling a rise in stock prices.
FII investment is viewed as compensating in some way for the relatively low
levels of foreign direct investment (FDI) and as a welcome sign of international
interest in the Indian economy. At the same time, there is unease over the
impact of volatility in FII flows on the stock market and the Indian economy.
In the first year of allowing FII participation in the Indian markets (1992-93),
inflows though this route was a mere USD 4 million. This increased to a net

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inflow of USD 1.6 bn in the following year. In each of the subsequent years, the
net inflows from FIIs have been positive (except for in 1998-99 when there were
events such as the Pokhran nuclear detonation, the Kargil tensions etc). The net
FII inflow in Indian equities was $8 billion in 2006.
SENSEX, India’s benchmark index has been breaking all kinds of records and
creating new historical highs and Indian GDP has also been growing at a very
good pace. All these can be partially attributed to foreign investors .So this
motivated me to carry out the study on Foreign Institutional Investors and their
impact on the Indian stock market.
This study therefore explores the relationship between the net foreign
institutional investment flows and SENSEX, identifying the impact of net FII flows
and SENSEX on each other, if any.
1.2 Research Objectives
1.2.1 Statement of the Problem

The stock market is influenced by many factors. Both institutional and individual
investors have a critical role to play in the stock market. The volatility in the
market is the result of buying and selling pressure on the stocks. The excessive
buying pressure results in the bull market and the excessive selling pressure
result in bear market. Under these circumstances it may be useful to study the
impact of institutional investors on the market. This study basically aims at
studying the influence of Foreign Institutional Investors on the Indian stock
market.

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1.2.2 Objectives of the study

The main objectives of the study is
• To study the impact of FII investments on stock market liquidity
• To investigate causality between SENSEX and net FII flow
1.2.3 Scope of the study

The rise in equity prices in emerging markets has happened on account of a
surge in foreign inflows in recent years. India has turned out to be one of the
favourite markets for the Foreign Institutional Investors (FIIs). FIIs are
understood to play a vital role in Indian stock market. But the scope of the study
is limited to the impact of FII investments in equity market.

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2. Literature Review
Linkages between financial markets across geographical boundaries as well as

the impact of one market on another have been the object of many studies. The
importance of such studies has come to the fore in recent years owing to events
like sudden ups and downs in the equity market.
There have been several studies in the last few years relating to the movement
of indices in Indian financial markets with the changes in foreign institutional
investment (FII) investment. Some studies have suggested that the
strengthening of Indian financial markets has been because of the influence of
FII.
Pan (2006) certified the positive correlation between BSE SENSEX and FII
inflows by analyzing the monthly trend of FIIs inflows and BSE SENSEX and
inferred that “The upswings in the FII inflows from around May 2003 have also
led to quantum jumps in the BSE SENSEX. But despite the general upward
trajectory of the BSE SENSEX there have been some months of correction and
such corrections occurred in months with negative FII flows. Only in the recent
period of the past 5 years, FII activity has become more important in the total
activity level in the equity market and logically leading to an increase in their
ability to swing the market either way.”
Parthapratim Pal (2005) in his detailed study on “Volatility in stock markets in

India and FIIs” has concluded that not only are the FIIs major players in the
domestic stock market in India, but their influence on the domestic markets is
also growing. “The influence of FIIs on the movement of the SENSEX became
apparent after the 2004 general elections in India when the sudden reversal of

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FII flows triggered a panic reaction which resulted in very high volatility in the
Indian stock market.”
However a study by Ashok Banerjee & Sahadeb Sarkar (2006) has shown that
the FIIs’ participation in the Indian stock market over a period of time has not led
to a significant increase in the market volatility.
According to Mukherjee, Bose and Coondoo (2002), contrary to the general

perception of FII activities having a strong demonstration effect and driving the
domestic stock market in India, evidence from causality tests suggests that FII
flows to and from the Indian market tend to be caused by return in the domestic
equity market and not the other way round. They find, in particular, that Indian
equity market returns is an important (perhaps the most important) factor
influencing FII inflow, but not influencing FII outflow.
Chandrasekhar (2005) also suspect that the stock price spiral is largely because
of surging FII inflows and is not based on the fundamental strength of the Indian
economy or the Indian companies. “Movements in the SENSEX during these two
years have clearly been driven by the behavior of FIIs. The sudden FII interest in
Indian markets in the last two years account for the two bouts of medium-term
buoyancy that the SENSEX recently displayed.”
In a recent article published by the Market Bureau of the Financial Express, the
FIIs are perceived to be the drivers of the Indian equity market. “The
dependence of the Indian equity markets on the foreign investors is further
proved by the fact that in the period between May 10, 2006 and June 14, 2006,
when the SENSEX moved from a high of 12,612.38 to a low of 8,928.44, FIIs
were net sellers at nearly Rs 9,500 crore.

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3. The Indian Capital Market

3.1 The Indian Capital Market - An Overview
The function of the financial market is to facilitate the transfer of funds from
surplus sectors (lenders) to deficit sectors (borrowers). Normally, households
have investible funds or savings, which they lend to borrowers in the corporate
and public sectors whose requirement of funds far exceeds their savings. A
financial market consists of investors or buyers of securities, borrowers or sellers
of securities, intermediaries and regulatory bodies. Financial market does not
refer to a physical location. Formal trading rules, relationships and
communication networks for originating and trading financial securities link the
participants in the market.
Indian financial system consists of money market and capital market.
Figure 2: Financial Market
Financial
Market
Money
Capital
Market
Market
Financial Securities
Institutions Market
Primary Secondary
Government Securities Corporate Securities Derivative

(Debt and Equity) (Debt and Equity) Market

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Options Futures
Market Market
The money market has two components - the organised and the unorganised.
The organized market is dominated by commercial banks. The other major
participants are the Reserve Bank of India, Life Insurance Corporation, General
Insurance Corporation, Unit Trust of India, Discount and Finance House of India,
other primary dealers and mutual funds. The core of the money market is the
inter-bank call money market whereby short-term money borrowing/lending is
effected to manage temporary liquidity mismatches. The Reserve Bank of India
occupies a strategic position of managing market liquidity through open market
operations of government securities, access to its accommodation, cost (interest
rates), availability of credit and other monetary management tools. Normally,
monetary assets of short-term nature, generally less than one year, are dealt in
this market.
The unorganized sector of the money market comprises the indigenous bankers
and the moneylenders. In the unorganised market, there is no clear demarcation
between short-term and long-term finance and even between the purposes of
finance. The unorganised sector continues to provide finance for trade as well as
personal consumption. The inability of the poor to meet the "creditworthiness"
requirements of the banking sector make them take recourse to the institutions
that still remain outside the regulatory framework of banking. But this market is
shrinking.
The capital market consists of primary and secondary markets. The primary
market deals with the issue of new instruments by the corporate sector such as
equity shares, preference shares and debt instruments. Central and State
governments, various public sector industrial units (PSUs), statutory and other
authorities such as state electricity boards and port trusts also issue bonds/debt
instruments.
The secondary market mainly deals with the securities which are previously
issued and enables participants who hold securities to adjust their holdings in

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response to changes in their assessment of risk and return. Participants also sell
securities for cash to meet their liquidity needs. The secondary market has
further two components, namely Over-the-Counter (OTC) market and the
Exchange-Traded Market.
Over the Counter Market: OTC is different from the market place provided by the
Over the Counter Exchange of India Limited. It is a telephone and computer
linked network for dealers who do not meet physically. Over the counter markets
are generally informal markets where trades are negotiated. Most of the trades in
government securities are in over the counter market. All the spot trades where
securities are traded for immediate delivery and payment take place in OTC
market.
Exchange Traded Market: Exchange traded markets are those markets where
trade takes place under certain organized exchange. Bombay Stock Exchange
(BSE) and National Stock Exchange (NSE) are the major stock Exchanges in
India. The Exchanges don’t provide facility for spot trades in a strict sense.
Closest to spot market is the cash market where settlement takes place after
some time. Trades taking place over a trading cycle, i.e. a day under rolling
settlement, are settled together after a certain time (currently 2 working days). All
the 23 stock exchanges in the country provide facilities for trading of equities.
Trades executed on the leading exchanges are cleared and settled by a clearing
corporation which provides ovation and settlement guarantee. Nearly 100% of
the trades settled by delivery are settled in demat form. All leading exchanges
are regulated and controlled by Securities and exchange Board of India (SEBI).
Capital Market Participants: There are several major players in the primary
market. These include the merchant bankers, mutual funds, financial institutions,
foreign institutional investors (FIIs) and individual investors. In the secondary
market, there are the stock exchanges, stock brokers (who are members of the
stock exchanges), the mutual funds, financial institutions, foreign institutional
investors (FIIs), and individual investors. Registrars and Transfer Agents,

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Custodians and Depositories are capital market intermediaries that provide

important infrastructure services for both primary and secondary markets.
Market Regulation:
The financial market in India was highly segmented until the initiation of reforms
in 1992-93 on account of a variety of regulations and administered prices
including barriers to entry. The reform process was initiated with the
establishment of Securities and Exchange Board of India (SEBI).
SEBI
In 1988 the Securities and Exchange Board of India (SEBI) was established by
the Government of India through an executive resolution, and was subsequently
upgraded as a fully autonomous body (a statutory Board) in the year 1992 with
the passing of the Securities and Exchange Board of India Act (SEBI Act) on
30th January 1992. In place of Government Control, a statutory and autonomous
regulatory board with defined responsibilities, to cover both development &
regulation of the market, and independent powers have been set up.
Paradoxically this is a positive outcome of the Securities Scam of 1990-91.
The basic objectives of the Board were identified as:
• to protect the interests of investors in securities;

• to promote the development of Securities Market;
• to regulate the securities market and
• for matters connected therewith or incidental thereto.
Since its inception SEBI has been working targeting the securities and is
attending to the fulfillment of its objectives with commendable zeal and dexterity.
The improvements in the securities markets like capitalization requirements,
margining, establishment of clearing corporations etc. reduced the risk of credit
and also reduced the market.
SEBI has introduced the comprehensive regulatory measures, prescribed

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registration norms, the eligibility criteria, the code of obligations and the code of
conduct for different intermediaries like, bankers to issue, merchant bankers,
brokers and sub-brokers, registrars, portfolio managers, credit rating agencies,
underwriters and others. It has framed bye-laws, risk identification and risk
management systems for Clearing houses of stock exchanges, surveillance
system etc. which has made dealing in securities both safe and transparent to
the end investor.
Two broad approaches of SEBI is to integrate the securities market at the

national level, and also to diversify the trading products, so that there is an
increase in number of traders including banks, financial institutions, insurance
companies, mutual funds, primary dealers etc. to transact through the
Exchanges. In this context the introduction of derivatives trading through Indian
Stock Exchanges permitted by SEBI in 2000 is a real landmark
Bombay Stock Exchange
Bombay Stock Exchange Limited is the oldest stock exchange in Asia with a rich
heritage. Popularly known as "BSE", it was established as "The Native Share &
Stock Brokers Association" in 1875. It is the first stock exchange in the country to
obtain permanent recognition in 1956 from the Government of India under the
Securities Contracts (Regulation) Act, 1956.The Exchange's pivotal and pre-
eminent role in the development of the Indian capital market is widely recognized
and its index, SENSEX, is tracked worldwide. Earlier an Association of Persons
(AOP), the Exchange is now a demutualised and corporatised entity incorporated
under the provisions of the Companies Act, 1956, pursuant to the BSE
(Corporatisation and Demutualisation) Scheme, 2005 notified by the Securities
and Exchange Board of India (SEBI).
The Exchange has a nation-wide reach with a presence in 417 cities and towns
of India. The systems and processes of the Exchange are designed to safeguard
market integrity and enhance transparency in operations. The Exchange

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provides an efficient and transparent market for trading in equity, debt

instruments and derivatives
3.2 Foreign Investment
Foreign Investment refers to investments made by residents of a country in

financial assets and production process of another country. After the opening up
of the borders for capital movement these investments have grown in leaps and
bounds. But it had varied effects across the countries. It can affect the factor
productivity of the recipient country and can also affect the balance of payments.
In developing countries there was a great need of foreign capital, not only to
increase their productivity of labor but also helps to build the foreign exchange
reserves to meet the trade deficit. Foreign investment provides a channel
through which these countries can have access to foreign capital. It can come in
two forms: foreign direct investment (FDI) and foreign portfolio investment (FPI).
Foreign direct investment involves in the direct production activity and also of
medium to long-term nature. But the foreign portfolio investment is a short-term
investment mostly in the financial markets and it consists of Foreign Institutional
Investment (FII).
Figure 3 schematically shows how foreign portfolio investment can affect the
economy through the stock markets.

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Figure 3: Diagrammatic Representation of how Foreign Funds encourage

Domestic Secondary and Primary Market.
Source: Foreign Portfolio Investment, Stock Market and Economic Development:

A Case Study of India, Parthapratim Pal, 2006
3.2.1 Foreign Institutional Investor Defined

A Foreign Institutional Investor or FII is any institution established or incorporated
outside India and intends to make investment in India in securities. According to
SEBI, FIIs including institutions like pension funds, investment trusts, asset
management companies, nominee companies and incorporated/institutional
portfolio managers or their power of attorney holders (providing discretionary and
non-discretionary portfolio management services) can make investment in India.
Further ,FIIs can also make investment in India on behalf of sub-accounts ,which
include foreign corporates or individuals and institutions established or

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incorporated outside India and funds or portfolios established outside India

whether incorporated or not. Further the domestic asset management companies
or portfolio managers can also register as FII and manage the sub account.
3.2.2 Evolution of FII

With an intention of having an outward oriented economy that interacts with rest
of the world apart from bringing about considerable growth, the Government of
India in 1991 took up liberalization and economic reforms. One of the significant
aspects of these reforms was the opening up of Indian capital market to global
players. For the first time ever, the Government of India permitted the FIIs,
Overseas Corporate Bodies (OCBs) and Non-Resident Indians (NRI) to invest in
the Indian capital market subject to some restrictions. In consonance with this
decision, the Finance Ministry came up with guidelines on September 14,
1992.Since then, the guidelines have been amended from time to time to keep
liberalizing the foreign investment further. In 1995, the guidelines were suitably
incorporated in the regulations and in 2000 when Foreign Exchange
Management Act came into force, regulations were issued regarding foreign
exchange controls in the RBI permitting foreign transactions of FIIs.
3.2.3 Benefits of FII Investments

Reduced cost of equity capital
FIIs operating in Indian capital market have eventually assumed a position so
vital that its not practical to mention the stock prices without an elaborate
discussion about their impact on the cost of equity capital. FII investment
reduces the required rate of return for equity, enhances stock prices, and fosters
investment by Indian firms in the country.
Imparting stability to India's Balance of Payments

It becomes imperative for a developing economy like India to have a
comprehensive expansion of domestic investment, over and beyond the
domestic savings, through capital flows. The excess of domestic investment over

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domestic savings result in a current account deficit and this deficit is financed by
capital flows in the balance of payments. Prior to 1991, debt flows and official
development assistance dominated these capital flows. Portfolio flows in the
equity markets, and FDI, as opposed to debt-creating flows, are important as
safer and more sustainable mechanisms for funding the current account deficit.
Knowledge flows
The activities of international institutional investors help strengthen Indian
finance. FIIs advocate modern ideas in market design, promote innovation,
development of sophisticated products such as financial derivatives, enhance
competition in financial intermediation, and lead to spillovers of human capital by
exposing Indian participants to modern financial techniques, and international
best practices and systems.
Strengthening corporate governance

Domestic institutional and individual investors accept ongoing practices of Indian
corporates even when these do not measure up to the international benchmarks
of best practices. FIIs, with their vast experience with modern corporate
governance practices, are less tolerant of malpractice by corporate managers
and owners (dominant shareholder). FII participation in domestic capital markets
often lead to vigorous advocacy of sound corporate governance practices,
improved efficiency and better shareholder value.
Improvements to market efficiency

A significant presence of FIIs in India can improve market efficiency through two
channels. First, when adverse macroeconomic news, such as a bad monsoon,
unsettles many domestic investors, it may be easier for a globally diversified
portfolio manager to be more dispassionate about India's prospects, and engage
in stabilising trades. Second, at the level of individual stocks and industries, FIIs
may act as a channel through which knowledge and ideas about valuation of a
firm or an industry can more rapidly propagate into India. For example, foreign

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investors were rapidly able to assess the potential of firms like Infosys, which are
primarily export-oriented, applying valuation principles that prevailed outside
India for software services companies.
3.2.4 A Gist of the FII Guidelines and Regulations
• Investment by FIIs is regulated under SEBI (FII) Regulations, 1995 and
Regulation 5(2) of FEMA Notification No.20 dated May 3, 2000. SEBI acts
as the nodal point in the entire process of FII registration.
• The FIIs inclined to purchase, sell or deal in Indian securities need to

obtain a initial registration from the capital market regulator, SEBI. The
nominee companies, affiliates and subsidiary companies of a FII will be
regarded as individual FIIs for the purpose of registration. The prospective
FIIs shall hold a certificate of registration from the stock market regulatory
organization in the country of their domicile. The initial registration issued
by SEBI will be valid for a period of 5 years. After expiry of 5 years, the
registration needs to be renewed.
• The FII can invest in securities traded on the primary and secondary
markets including shares, debentures and warrants of companies,
unlisted, listed or to be listed on a recognized stock exchange as well as
dated governments securities, derivatives traded on a recognized stock
exchange, commercial papers and units of mutual funds.
• SEBI will grant the initial registration to FII after verifying the track record,
professional competency, financial soundness, experiences and other
relevant criteria.
• In line with the foreign exchange controls in force, FII will have to file with
SEBI an application addressing RBI to seek various permissions. Upon
receipt of fees from the applicant and FEMA approval from Reserve Bank
of India , SEBI grants the certificate of registration

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• There are two categories of FII registered with SEBI

1. Regular FIIs who can invest 70% of their total investments in equity
and equity related instruments and 30% in non-equity instruments.
2. FIIs with 100% debt funds, who can invest only in debt instruments.
• All FIIs and their sub-accounts taken together cannot acquire more than
24% of the paid up capital of an Indian Company. Indian Companies can
raise the above mentioned 24% ceiling to the Sectoral Cap / Statutory
Ceiling by passing a resolution by its Board of Directors followed by
passing a Special Resolution to that effect by its General Body.
• No individual FII/sub-account can acquire more than 10% of the paid up

capital of an Indian company. Broad-based / Proprietary sub-accounts are
allowed to individually invest upto 10% of the total issued capital.
• Investments by each sub-account in the category Foreign Corporates and

foreign individuals should not exceed 5% of the issued capital
• The investment ceilings of FII/NRI/PIO are monitored on a daily basis by

the RBI and it has put in place a cut-off point that is 2 percentage less
than the ceiling rate. The RBI grants investment till the aggregate ceiling
limit when the link offices approach them on reaching the cut-off mark.
Once the aggregate limits or sectoral caps are reached, RBI directs the
banks not to purchase any shares on behalf of FII/NRI/PIO without its
prior approval.

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• No permission from RBI is needed so long as the FIIs purchase and sell
on recognized stock exchange. All non-stock exchange sales/purchases
require RBI permission
Of late, FIIs have been investing in Participatory Notes (PNs) also. A

‘Participatory Note’ is a derivative instrument issued by FIIs registered in the
country to foreign investors who like FIIs are not registered with SEBI but want
an exposure to Indian equities. In a way it is an understanding between a foreign
investor who is registered here and the other one who is not registered.
Underlying securities in Participatory notes are Indian stocks. The overseas
investor deposits the funds in the European or the US operations of FII who
purchase stocks on their behalf. In due course of these transactions, the FII acts
as an exchange by executing and settling the trades.
3.2.5 FIIs Registered in India

The number of Foreign Institutional Investors registered with the Securities and
Exchange Board of India (Sebi) crossed the 1,000 mark.
The total number of FIIs having their offices in India has increased to 1,030 till
December 28, 2006. In the beginning of calendar year 2006, the figure was 813.
As many as 217 new FIIs opened their offices in India during 2006. This is the
highest number of registrations by FIIs in a year till date. The previous highest
was 209 in 2005.
As many as 37 foreign entities registered with the market regulator till December
28, 2006 highest ever single month registrations by the FIIs since their entry into
Indian market in 1993.
In 1993, Pictet Umbrella Trust Emerging Markets’ Fund, an institutional investor

from Switzerland, was the only FII to enter the Indian market.

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While in 1994, no new registrations were reported, between 1995 and 2003, an
average of 51 new FIIs opened their shops in the country each year. The number
of new registrations with the Sebi increased to 144 in 2004 and 209 in 2005.
It can be observed from Figure 4 that out of 1,030 FIIs (till December 2006) from
42 different countries, as many as 388 FIIs are from the US, 167 from the Great
Britain, 73 from Luxembourg, 51 from Singapore, 35 each from Australia and
Hong Kong, 32 from Canada, 29 from Ireland, 27 from Netherlands, 25 from
Mauritius, 22 from Switzerland and 20 from France.
Figure 4: Country wise breakdown of FIIs registered in India
Country wise breakdown of FIIs Registered in India
Others, 176, 17%
USA, 338, 34%

France, 20, 2%
Switzerland , 22, 2%
Mauritius, 25, 2%
Netherland, 27, 3%
Ireland, 29, 3%
Canada, 32, 3%
Hong Kong, 35, 3%
Australia, 35, 3%
Singapore, 51, 5% United Kingdom,
167, 16%
Luxembourg, 73, 7%
3.2.6 Contribution by FIIs
Positive tidings about the Indian economy combined with a fast-growing market
have made India an attractive destination for foreign institutional investors (FIIs).

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The diversity of FIIs has been increasing with over 1030 FIIs from over 30
countries, registered with SEBI as at December 31st, 2006. Of these, 34%
originate from the US and 16% from the UK. Recently FIIs from Japan and
continental Europe are increasing their India exposure.
The fact that FIIs have always been loyal to the Indian markets can be witnessed
by their contribution in all the main rallies since the time the SENSEX touched
5000. It can be observed from Table 1 that between 5000 and 14000, FIIs have
pumped in money in the range of Rs 76.30 crore- Rs 1017.20 crore.
Table 1: FIIs Contribution in major SENSEX rallies
FIIs contribution(Rs core)

Sensex's milestones FII contribution
5000 76.3
6000 76.6
7000 298.9
8000 543.2
9000 420.1
10000 935.6
11000 550.2
12000 224.9
13000 1017.2
14000 433.2
Source: Moneycontrol.com (20-12-2006)
FIIs constituted approximately 11% of the total market and approximately 10% of
the total market turnover in FY 2006.
Of the new issuances in FY 2006 FIIs contributed over 75 % of new equity and
equity-linked issuances. Evidently FIIs supplement domestic savings and
augment domestic investment without increasing foreign debt.
3.2.7 FII Inflows to India

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The rise in equity prices in emerging markets has happened on account of a

surge in foreign inflows in recent years. India is part of this surge. FII investment
in emerging countries over a period of 10 years is shown in the Table 2
Table 2 :FII Investment in emerging markets(in USD Mn)

India Indonesi Korea Phillippines Taiwan Thailand EM Asia
a (Excluding
Malaysia)
2006 2579 832 -3168 488 6252 1448 8431
YTD
2005 10546 -1741 3584 355 24389 2976 40109
2004 8430 2191 11212 319 8140 119 30411
2003 6595 1117 12430 -82 13542 -634 32968
2002 751 856 -2015 -53 517 289 345
2001 2802 441 6875 86 8161 -149 18216
2000 1593 86 11238 -123 5127 -828 17093
1999 1724 1595 1197 400 8261 -65 13112
1998 -148 526 3314 264 749 679 5384
1997 1569 130 526 -406 -227 1811 3403
1996 3036 1837 3933 2101 2194 499 13600
(Source: Dalal Street Journal,June 26-July9, 2006)
It can be observed from Figure 5 that net FII inflows into India increased steadily
through the decade of the 1990s to $8 billion in 2006 compared to a record
inflow of $10.7 billion in 2005 The cumulative FII inflow till December 31, 2006
has been $49.09 billion from $4 million in 1992, reflecting the strong economic
fundamentals of the country, as well as confidence of the foreign investors in the
growth and stability of the Indian market. Every year since FIIs were allowed to
participate in the Indian market, FII net inflows into India have been positive,
except for 1998-99.The decline during 1998-99 was due to the nuclear tests and
East Asian Crisis but their effects were short lived.
Figure 5: Net FII flows to India

23
Net FII flows to India
50000
40000
Crore(Rupees)
30000
20000 Net
10000
0
19 93
19 9 5
19 96
19 9 8
20 01
20 0 4
6
19 94
19 97
19 99
20 00
20 02
20 03
20 05
-10000
-0
-
-
92
93
94
95
96
97
98
99
00
01
02
03
04
05
19
.
3.2.8 FII versus FDI
According to the International Monetary Fund’s Balance of Payments Manual 5,

FDI is that category of international investment that reflects the objective of
obtaining a lasting interest by a resident entity in one economy in an enterprise
resident in another economy. The lasting interest implies the existence of a long-
term relationship between the direct investor and the enterprise and a significant
degree of influence by the investor in the management of the enterprise.
According to EU law, foreign investment is labeled direct investment when the
investor buys more than 10 per cent of the investment target, and portfolio
investment when the acquired stake is less than 10 per cent. Institutional
investors on the other hand are specialized financial intermediaries managing
savings collectively on behalf of investors, especially small investors, towards
specific objectives in terms of risk, returns, and maturity of claims.
While permitting foreign firms/high net worth individuals in February, 2000 to
invest through SEBI registered FII/domestic fund managers, it was noted that
there was a clear distinction between portfolio investment and FDI. The basic
presumption is that FIIs are not interested in management control. To allay fears

24
of management control being exercised by portfolio investors, it was noted that

adequate safety nets were in force, for example, (i) transaction of business in
securities on the stock exchanges are only through stock brokers who have been
granted a certificate by SEBI, (ii) every transaction is settled through a custodian
who is under obligation to report to SEBI and RBI for all transactions on a daily
basis, (iii) provisions of SEBI (Substantial Acquisition of Shares and Takeovers)
Regulations, 1997 (iv) monitoring of sectoral caps by RBI on a daily basis.
There is often a popular preference for FDI over FII on the assumption that FIIs
are fair-weather friends, who come when there is money to be made and leave
at the first sign of impending trouble. FDI, by contrast, have a lasting interest in
their company and stay with it through thick or thin. While there is some justified
strength in this preference, some further arguments need to be taken into
account while exercising the choice. First, all portfolio investors, whether
domestic or foreign, are ‘fair-weather’ friends, and exit as soon as there is
evidence that they will lose money by staying invested in a particular company.
Second, the strength of domestic home-grown entrepreneurship in India is widely
acknowledged. Because of this strength, some commentators describe the
Indian growth process as an organic one. This entrepreneur class may prefer to
have portfolio investors who share the project and business risk without
interfering in the critical management decisions of the company. Thus, there may
be a preference for FII over FDI as far as this class is concerned. This
preference has a close analogy with the choice between allowing a strategic
investor to have management control in a public sector company and allowing a
diversified mutual fund to hold a large part of the shares of such a company.
Finally, if there is intent to encourage FDI, then this constitutes a case for easing
restrictions upon FDI-style control oriented purchases by portfolio investors
which is done through FII.
According to Shah and Patnaik (2004): “Net FDI flows into India have remained
small, either when compared with Indian GDP or when compared to global FDI
flows. In contrast with the Chinese experience, relatively little FDI has come into

25
India in setting up factories which are 21 parts of global production chains. This
may be associated with infirmities of Indian indirect taxes and transportation
infrastructure. India is more important as a platform for services production as a
part of global production chains, where difficulties of indirect taxes and
transportation infrastructure are less important. However, services production is
less capital intensive, and induces smaller net FDI flows. Given the size of the
Indian economy, and the relative lack of correlation with the global business
cycle, Indian equities have had low correlations with global risk factors. In
addition, India has fared well in creating the institutional mechanisms of a
modern, liquid equity market. India’s share in global portfolio flows is higher than
India’s share in global FDI flows, and net portfolio flows are substantial when
compared to Indian GDP.
Fig. 6: Total Foreign Investment, FDI and FII flows (net):1995-96 to 2004-05
Source: Economic Survey 2005-2006
India has one of the highest exposures to FII inflows among other emerging
economies. While in India, FIIs formed nearly 70 per cent of foreign investment
(FDI plus net portfolio equity flows) flow, in China and Brazil the percentage was
26 per cent and 30 per cent, respectively, for '05. Unlike India, a major chunk of
foreign investment entered China, Brazil and Russia as FDI.

26
India, on the other hand, attracted nearly 20% of the net portfolio investments
flowing into developing countries, while its FDI inflows were barely 2.4% of what
was received by emerging economies, according to data from the Global
Development Finance report ‘06.
During January-December ‘05, while India’s current account deficit stood at

$13bn, it had a large capital account surplus amounting to $26bn. Nearly half of
these inflows, however, were portfolio investments considered volatile by RBI.
In comparison, not only are the other three BRIC economies running a surplus in
their current account, Brazil and Russia received nearly $15bn of FDI each in
‘05, and China received close to $53bn, forming a substantial portion of the
capital inflows. India, on the other hand, received barely $6.5bn.
With FDI inflows stuck at the $5-6bn range, the country has been unable to
attract larger direct investments inspite of a GDP growth of 8%, which is higher
than Brazil and Russia’s growth rate.
Not surprisingly, India’s FDI inflows as a percentage of GDP were barely 0.8%
compared to 1.8% for Brazil and Russia and 2.7% for China. Interestingly, in
Brazil and Russia, even with heavy FDI inflows, the capital and financial account
of both these economies ended in the red in ‘05.
This is primarily because of the prepayment of debt owed by them to the IMF
and the Paris Club. Moreover, in Russia’s case, there were large commercial
borrowings as well as heavy investments abroad by Russian companies.
In fact, while Russia received $77bn as private capital inflows, Russian

corporations and banks invested nearly $66bn abroad during the year.
Recent developments

27
According to The Economic Times, January 17, 2007 edition the government is
examining the possibility of redefining foreign investments in companies by
removing the distinction between FDI and FII investments.
At present, investments by GE Capital, for instance, are termed as FII, while

funds from GE are bracketed as FDI. This, despite the fact that GE Capital could
be a subsidiary of GE. And in sectors which have a cap on investments, matters
are even more complicated. In such a situation, treating all foreign investments,
irrespective of FDI or FII, as the same when it comes to investment limits and
conditions could be seen as a more realistic approach.
Once the changes are in place, the policy would be more in tune with
investments in developed countries where the distinctions between FDI and FII
are fast disappearing.
As reported in Financial Express, January 12, 2007, the Prime Minister’s

Economic Advisory Council (EAC) has projected that for the first time in recent
years FDI is likely to exceed FII. According to the EAC, net FDI for 2006-07
would be around $9 billion, up from $4.7 billion last year while FII or portfolio
inflows are likely to be $7 billion.
3.2.9 Advantages to FIIs
1. Institutional investors have an edge over the private investors as they are
equipped with the resources to analyze the relevant financial information
which enables them to earn higher returns

28
2. Further, the large volumes of funds permit then them to hold well-
diversified portfolios and thereby earn higher returns for less risk.
3.2.10 Disadvantages to FIIs
1. A large part of the FII funds are dealt by agents like domestic depository,
designated banks ,whose interests are different and conflicts with that of
the institution.
2. The FIIs often exhibit herd mentality due to which a wrong move by one of
the participants could adversely affect the remaining participants too.
4. Data and Methodology

The study is empirical in nature, using secondary data only. The data for the
study consists of closing price of SENSEX reported by BSE on a daily basis,
monthly market capitalization of BSE, monthly net FII flows and daily net FII

29
flows (i.e. inflows minus outflows).The data source was SEBI, The Economic
Times, BSE, Moneycontrol , myiris websites and several monthly publication of
CMIE Economic Review.
The study spans for the period from January 2000 to December 2006.During this
period SEBI/RBI initiated various policy initiatives, guidelines and enacted
investment limit of FII’s from time to time in the capital market.
One of the objectives of the study was to investigate causality between SENSEX
and net FII flow. For this purpose, following Granger (1969), the linear Granger
causality tests were employed. The Granger causality tests involve the
estimation of the following models:
m1 m2
∆S t = α 1 + ∑ β1i ∆S t −i + ∑ γ 1i ∆Ft − j + ε 1t
i =1 j =1
m1′ m′2
∆Ft = α 2 + ∑ β 2i ∆Ft −i + ∑ γ 2i ∆S t − j + ε 2t ,
i =1 j =1
Where ∆S t = S t − S t −1 is the first order forward difference in the daily closing

prices of the BSE SENSEX and ∆Ft = Ft − Ft −1 is the first order forward
difference in the net FII flows; α, β, γ are the parameters to be estimated, and ε1,
ε2 are standard random errors with zero mean and constant variance. Finally, the
orders m1 , m2 , m1′ , m′2 are the optimal lags chosen by Akaike’s (1969)
information criterion. In order to test the significance of γ 1 and γ2, F-statistic was
employed:
( SSER − SSEUR )
(df R − dfUR )
F=
MSEUR
The equations above provide a convenient framework for examining linear

causality relationships. If the estimated lagged coefficient vector γ1 is statistically

30
significant while the estimated lagged coefficient vector γ2 is not statistically

significant, then it can be inferred that net FII flows Granger cause changes in
SENSEX with no feedback (i.e. a unidirectional causality exists from net FII flows
to SENSEX), implying that knowledge of past values of net FII flows improves
the predictions of changes in SENSEX, while knowledge of past values of
changes in SENSEX has no predictive power over net FII flows. On the other
hand, if the estimated lagged coefficient vector γ 1 is not statistically significant
while the estimated lagged coefficient vector γ2 is statistically significant, then it
can be inferred that changes in SENSEX Granger cause changes in net FII flows
with no feedback (i.e. a unidirectional causality exists from SENSEX to net FII
flows), implying that knowledge of past values of changes in SENSEX improves
the predictions of changes in net FII flows, while knowledge of past values of
changes in net FII flows has no predictive power over changes in SENSEX. If
both estimated lagged coefficient vectors γ1 and γ2 are statistically significant, the
bi-directional causality exists, implying that knowledge of past values of either
variable is useful in the prediction of the other. Finally, if neither estimated lagged
coefficient vectors γ1 and γ2 are statistically significant, then no causality exists
between net FII flows and changes in SENSEX.
5. Analysis and Interpretation

31
5.1 Descriptive Analysis

The distribution of monthly net FII flows is shown in Figure 7. It can be seen from
the graph that the year 2003 marked a turning point in FII investment in India.
FIIs started the year 2003 in a big way by investing Rs 888.1 crore in January
itself. Meanwhile, corporate India continued to report good operational results.
This, along with good macroeconomic fundamentals, growing industrial and
service sectors led FIIs to perceive great potential for investment in the Indian
economy. In April 2003, prices of commodities like steel and aluminium went up,
increasing FII investment in June 2003 to Rs 2581.7 crore. Calendar year 2004
ended with net FII inflows of US$9.2 billion. The buoyant inflows continued in
2005. In 2005, after reversing direction briefly during the period May -June, FII
inflows became robust again, leading to net inflows of US$ 10.7 billion during the
year, an all-time high since the liberalization. Indian stock markets witnessed a
great fall in the month of May 2006 and FII were net sellers in this month with net
sales of US$ 1.6 billion. However after that the inflows became robust again
leading to net inflows of $8 billion in the calendar year 2006.
Figure 7: Distribution of Net FII flows (Monthly)

12000
10000
8000
6000
In Rs crore
4000
2000
0
1
O 1
O 3
O 5
O 6
O 2
O 4
Ja 2
Ja 4
6
Ja 1
Ja 3
Ja 5
1
6
3
5
l-0
l-0
l-0
l-0
l-0
l-0
0
-0
-0
-0
-0
-0
-0
-0
-0
-0
-0
-0
-0
-2000
n-
n-
n-
n-
n-
n-
ct
ct
ct
ct
ct
ct
Ju
Ju
Ju
Ju
Ju
Ju
pr
pr
pr
pr
pr
pr
Ja
-4000
-6000
-8000
-10000
The distribution of daily net FII flows in the sample period is shown in Figure 8,
and the descriptive statistics of daily net FII flows is shown in table 1. The overall
mean daily net FII flow was Rs 112.8 crore, with standard deviation Rs 332.45

32
crore, indicating high variability in daily net FII flows. Also more than 80% of the
daily net FII flows was within the range -Rs 750 crore – +Rs 1250 crore, with very
few extreme values
Figure 8: Distribution of daily net FII flows

1000
800
600
400
200
Std. Dev=332.45
Mean=112.8
0 N=1493.00
-2
-2
-1
-1
-7
-2
3
5
2
7
5
5
.0
.0
0
0
.0
.0
.0
.0
.0
.0
.0
.0
.0
.0
.0
Net FII Inflow
Table 3: Descriptive Statistics of daily net FII flows
N
Valid 1493
Missing 249
Mean 112.771
Std. Deviation 332.445
Skewness 1.065
Std. Error of Skewness .063
Kurtosis 23.396
Std. Error of Kurtosis .127
Minimum -2813.8
Maximum 3490.5
5.2 Impact of FII investments on Stock Market Liquidity

In recent times, the boom in the Indian stock markets is frequently making
headlines in the important newspapers. The Indian stock market entered a new

33
bull phase in November 2004 .The BSE SENSEX crossed the 7700 mark in July
2005 and is fully gaining strength. The market ended calendar 2006 on a strong
note, with the SENSEX settling at 13,786.91, less than 200 points off its all time
closing high of 13,972.03 of 7 December 2006. The BSE SENSEX touched a
new intra-day record high of 14,462.77 and closed at an all-time closing peak of
14,403.77 on 2 February 2007.
A major factor that has been driving the SENSEX to new highs has been the
increasing liquidity in the Indian stock market, with strong flows from FIIs. Infact,
in recent times, the number of FIIs registering with SEBI has gone up sharply
from 637 in 2004 to 1057 as on 4 February 2007 resulting in sharp increase in
inflows. The net inflows from FIIs during 2007 have been Rs 492.1 crore as on
31 January 2007 and experts believe that this year could see the FII inflows
surpassing 2006’s number. Their optimism is based on the fact that the Indian
economy has been growing at a faster rate and attracting more and more FIIs
across the globe. The Japanese investors also came to India in 2005 for the first
time and have emerged as one of the biggest investors.
The stock market rally was ignited by FII inflows into the equity segment. This
pattern is examined by taking the proportion of FII investments in market
capitalization. Market capitalization refers to the value of the stock multiplied by
the total number of shares outstanding. The relationship between FII investments
and market capitalization indicates the degree of liquidity in the market. The
increased investment leads to the increased capital employed and vice versa in
the short run.
Table4:Investment Behavior of FIIs and Market Capitalization

Months Net Investment Cumulative Investment BSE Market Capitalization
(Rs Cr) (Rs Cr) (Rs Cr)
X Y
2000

34
January 151.2 35619 927383

February 2711.6 38330.6 1029257
March 1064.4 39395 912842
April 2690.5 42085.5 755914
May 484.1 42569.6 702777
June -952.9 41616.7 793230
July -1418 40198.7 720884
August 1346.2 41544.9 766642
September 142.5 41687.4 692757
October -271.7 41415.7 653437
November 932.6 42348.3 699229
December -576.9 41771.4 692565
2001
January 4045.5 45816.9 736631
February 1819.1 47636 716172
March 1972.9 49608.9 625553
April 1769.9 51378.8 567728
May 1046.5 52425.3 595938
June 715.3 53140.6 553230
July 722.4 53863 531576
August 437.5 54300.5 523036
September -415.6 53884.9 456263
October 715.7 54600.6 481851
November 150.6 54751.2 535724
December 250.2 55001.4 532328
2002
January 423.3 55424.7 544397
February 1966.3 57391 596716
March 391.3 57782.3 612224
April 11.6 57793.9 625587
May -56 57737.9 605065
June -381.1 57356.8 637753
July 333.1 57689.9 584042
August 240.3 57930.2 605303
September 468.6 58398.8 570273
October -776.4 57622.4 563750
November 601.8 58224.2 601289
December 427.2 58651.4 628197
2003
January 888.1 59539.5 611472
February 378.7 59918.2 619873
March 411.7 60329.9 572197
April 430.3 60760.2 572526
May 1220.8 61981 660982
June 2581.7 64562.7 734389
July 2346.5 66909.2 775996
August 2091.3 69000.5 905193
September 3851.3 72851.8 933087
October 6797.5 79649.3 1000494
November 3300.5 82949.8 1065853
December 6161.1 89110.9 1273361
2004
January 3176.8 92287.7 1206854

35
February 2397.5 94685.2 1196221

March 5604.4 100289.6 1201207
April 7638.2 107927.8 1255347
May -3246.9 104680.9 1023131
June 516.4 105197.3 1047258
July 913.6 106110.9 1135589
August 2892.3 109003.2 1216566
September 2385.6 111388.8 1309318
October 3263.3 114652.1 1337191
November 6740.8 121392.9 1539594
December 6683.8 128076.7 1685989
2005
January 457.1 128533.8 1661533
February 8376.3 136910.1 1730941
March 7502.2 144412.3 1698428
April -654.1 143758.2 1635766
May -1140.1 142618.1 1783221
June 5328.6 147946.7 1850377
July 7934.1 155880.8 1987170
August 5051.2 160932 2123900
September 4646.8 165578.8 2254376
October -3693.9 161884.9 2065610
November 4038.7 165923.6 2323063
December 9335 175258.6 2489384
2006
January 3677.6 178936.2 2616193
February 7587.8 186524 2695542
March 6688.8 193212.8 3022189
April 521.9 193734.7 3255565
May -7354.2 186380.5 2842049
June 479.5 186860 2721677
July 1145.2 188005.2 2712143
August 4643.1 192648.3 2993779
September 5424.7 198073 3185678
October 8013.1 206086.1 3370674
November 9380.1 215466.2 3577306
December -3667.4 211798.8 3624355
Correlation Rxy 0.965

93
Coefficient of Determination (%)
13.267
t-Test (calculated) 3.246
t-.05 (table value)
The following points are observed from the table

36
 There has been steady growth in investment by FIIs in India over the
years. The highest amount of FIIs’ net investment was Rs 9380.1 crore
and was recorded in the month of November 2006.
 The calendar year 2005 has received a historic net inflow from FIIs to
the tune of Rs 47181.9 crore
 The correlation between FIIs’ cumulative net investment and market
capitalization on BSE was recorded 0.965
 This highly correlated relation also gives the higher percentage of
determination i.e. 93 % was observed on BSE. The higher percentage
of determination explains any change that has been taken place in
capital employed was because of the FIIs investment.
 This is also proved by the t-test .The calculated value of t is greater
than the table value. Hence, it says that the capital employed was
influenced by FII investments in BSE.
 The reasons for such enormous enthusiasm of FIIs in the Indian
capital market can be on account of the following ;
1. The Indian capital market is well structured, regulated and mature
market.
2. The optimistic growth rate in the GDP
3. Implementation of further capital market reform along with
liberalization of FII investment in India in different sectors,
4. The overseas investment companies’ mutual funds – the US, the
UK and other European countries, Japan find India a safe heaven
for investment.

37
5.3 Granger Causality Test

The Granger causality tests were performed to test the direction of causality
between daily net FII flows and SENSEX. In performing the Granger regressions,
a lag structure of twenty five lags was chosen, as autocorrelations in daily net FII
flows and SENSEX were significant up to twenty five lags.
Regression of first order difference in SENSEX on its lagged values and on first
order difference in daily net FII flows and its lagged values yielded the following
results:
R Adjusted R Square
Square
.145 .098
Sum of
Squares df Mean Square F Sig.
Regression 1897990.792 77 24649.23107 3.057299664 3.66E-16
Residual 11198700.06 1389 8062.419053
Total 13096690.86 1466
On the other hand, regression of first order difference in SENSEX on its lagged
values alone (i.e. the restricted vector autoregressive model) yielded the
following results:
R Adjusted R Square
Square
.109 .077

38
Sum of
Regression 1424565.431 51 27932.65552 3.386247673 4.7E-14
Residual 11672125.43 1415 8248.851891
Total 13096690.86 1466
The F-test for significance of effect of first order difference in net FII on first order
difference in SENSEX yielded:
Δ
ΔR- adjusted .R Critical
square square ΔF value
2.258462082 1.503593694
.036 .021
Thus, the results of the Granger causality regressions indicate that variation in
changes in net FII (and its lagged values) explained 2.1% of the variation in
changes in SENSEX and it was statistically significant at 5% level of significance.
Regression of first order difference in net FII on its lagged values and on first
order difference in SENSEX and its lagged values yielded the following results
R Adjusted R Square
Square
.478 .449
Sum of
Regression 99894897.32 77 1297336.329 16.52282605 9.3E-146
Residual 109061256 1389 78517.82287
Total 208956153.3 1466

39
On the other hand, regression of first order difference in daily net FII flows on its
lagged values alone yielded the following results:
R Adjusted R Square
Square
.407 .385
Sum of
Regression 85006782.05 51 1666799.648 19.0281038 3.2E-125
Residual 123949371.2 1415 87596.7288
Total 208956153.3 1466
The F-test for significance of effect of first order difference in SENSEX on first
order difference in daily net FII flows yielded:
Δ
ΔR- adjusted .R table
square square ΔF value
7.292864185 1.503593694
.071 .064
The results of the Granger causality regressions indicate that variation in

changes in SENSEX (and its lagged values) explained 6.4% of the variation in
changes in net FII, and this was statistically significant at 5% level of significance
Thus it can be concluded that there was bi-directional Granger causality .

40
6. Findings
• The FII investments in Indian equity market have shown a fluctuating
trend year after year.
• The overall mean daily net FII flow was Rs 112.8 crore and more than
80% of the daily net FII flows was within the range -Rs 750 crore – +Rs
1250 crore, with very few extreme values
• The correlation between FIIs’ cumulative net investment and market
capitalization on BSE was recorded 0.965
• This highly correlated relation also gave the higher percentage of
determination i.e. 93 % was observed on BSE. The higher percentage of
determination explains any change that has been taken place in capital
employed was because of the FIIs investment.
• The results of the Granger causality regressions indicate that variation in
changes in net FII (and its lagged values) explained 2.1% of the variation
in changes in SENSEX and it was statistically significant at 5% level of
significance.
• The results of the Granger causality regressions indicate that variation in
changes in SENSEX (and its lagged values) explained 6.4% of the
variation in changes in net FII, and this was statistically significant at 5%
level of significance

41
7. Conclusion
After the initiation of economic reforms in the early 1990s, the movement of
foreign capital flow has increased tremendously. This increase in capital
movement would be expected to have very significant impact on the domestic
real economy. Hence there is a great need to understand the behavior of these
flows to minimize the impact of this on the real economy.
A number of studies in the past have observed that investments by FIIs and the
movements of SENSEX are quite closely correlated in India and FIIs wield
significant influence on the movement of SENSEX (Pan 2006). A note by
National Stock Exchange “Indian Securities Markets: A review Vol IV, 2001” also
observes that FIIs have a disproportionately high level of influence on the market
sentiments and price trends. This is so because other market participants
perceive the FIIs to be infallible in their assessment of the market and tend to
follow the decisions taken by FIIs. This ‘herd instinct’ displayed by other market
participants amplifies the importance of FIIs in the domestic stock market in
India.
The results of the Granger causality tests indicate that there is bidirectional
Granger causality from changes in daily net FII flows to changes in SENSEX in
the short run; that is, in the short run, changes in daily net FII flows tend to cause
changes in SENSEX, and vice versa.
The worst-case scenario where foreign institutional investors suddenly remove

their capital overnight from Indian capital markets is of course a serious threat,
and would undoubtedly have drastic consequences for Indian capital markets

42
and the Indian economy as a whole. Therefore, the priority should be to stabilize
domestic markets so that any outflow from the country would not lead the
economy in the situation of crises (like East Asian crises).
There is possibly a need to gear up macro-economic policies to target other form
of foreign investments into the economy and reduce the over-reliance of the
economy on portfolio flows.
Also understanding the determinants of FII will help in predicting the behavior,
which is very important for any emerging economy as it would have larger impact
on the domestic financial markets in the short run and real impact in the long run.
Limitations:
• The study is based on the secondary data only.

• The study is restricted to the impact of FII flows on SENSEX only and its
effect on S&P CNX Nifty and macro economic variables such as
exchange rate has not been considered.
• FII investments in debt market has not been considered.
Scope for Further Research:
The increasing role of foreign institutional investors in the capital market can be
further analyzed and the effect of FIIs inflows can be extended to economic
variables like exchange rate.

43
References
Books
Misra, S.K. and Puri, V.K. (2004) Economic Environment of Business
NSE, NCFM Handbook for NSDL Depository Operations Module
Articles/Journals
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1

Figure 1: World Total Investable Capital Market

Total Investable Capital Market (December 31,2005)

All Other Stocks

1% Emerging Market Debt

Source: UBS Global Asset Management, Venture Economics, EnnisKnupp

ALLIANCE BUSINESS SCHOOL

well as responding to new challenges.

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1.1 Research Motivation

The emergence of Foreign Institutional Investors (FIIs) as a force in India’s

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1.2 Research Objectives

1.2.1 Statement of the Problem

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1.2.2 Objectives of the study

1.2.3 Scope of the study

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Linkages between financial markets across geographical boundaries as well as

Parthapratim Pal (2005) in his detailed study on “Volatility in stock markets in

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According to Mukherjee, Bose and Coondoo (2002), contrary to the general

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3. The Indian Capital Market

Figure 2: Financial Market

Government Securities Corporate Securities Derivative

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Custodians and Depositories are capital market intermediaries that provide

• to protect the interests of investors in securities;

SEBI has introduced the comprehensive regulatory measures, prescribed

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Two broad approaches of SEBI is to integrate the securities market at the

Bombay Stock Exchange

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provides an efficient and transparent market for trading in equity, debt

3.2 Foreign Investment

Foreign Investment refers to investments made by residents of a country in

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Figure 3: Diagrammatic Representation of how Foreign Funds encourage

Source: Foreign Portfolio Investment, Stock Market and Economic Development:

3.2.1 Foreign Institutional Investor Defined

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incorporated outside India and funds or portfolios established outside India

3.2.2 Evolution of FII

3.2.3 Benefits of FII Investments

Imparting stability to India's Balance of Payments

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Strengthening corporate governance

Improvements to market efficiency

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• The FIIs inclined to purchase, sell or deal in Indian securities need to

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• There are two categories of FII registered with SEBI

• No individual FII/sub-account can acquire more than 10% of the paid up

• Investments by each sub-account in the category Foreign Corporates and

• The investment ceilings of FII/NRI/PIO are monitored on a daily basis by

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Of late, FIIs have been investing in Participatory Notes (PNs) also. A

3.2.5 FIIs Registered in India

In 1993, Pictet Umbrella Trust Emerging Markets’ Fund, an institutional investor